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Sources of Finance

Financial Requirements: 1 2 3 Short –term Medium-term Long-term

Short-term

1 2 3 4 5 6 7 8

Bank credit Customer advances Trade Credit Factoring Accruals Commercial paper Deferred Income Installment credit

Medium –Term 1 Issue of Debentures 2 Issue of Preference Shares 3 Bank loans 4 Public deposits/Fixed deposits 5 Loans from Financial institutions Long-Term 1 Issue of Shares 2 Issue of debentures 3 Ploughing-back of profits 4 Loans from specialized financial institutions Security Financing Corporate securities can be classified under two categories (i) Ownership securities Equity Shares Preference Shares (ii) Creditorship securities Debentures .

or may get even a higher rate of dividend. Equity shareholders can demand refund of their capital only at the time of liquidation of a company. Characteristics of Equity Shares: 1 Maturity: Equity shares provide permanent capital to the company and cannot be Redeemed during the life time of the company. They may be paid a higher rate of dividend or they may not get anything. They Are known as ‘variable income security’. Equity capital is paid after meeting all other claims including that of preference shareholders. They have a claim on income left after paying dividends to preference Shareholders. They have a control over the working of the company. they may not get anything if profits are insufficient. 2 Claims/Right to Income: Equity shareholders have a residual claim on the income of a Company. These shareholder take more risk as compared to preference shareholders. They take risk both regarding dividend and return of capital. . The rate of dividend on these shares is not fixed. In many cases. The rate of dividend on these shares depends upon the profits of the company. The holders of these shares are the real owners of the company. it depend upon the earnings Available after paying dividends on preference shareholders.Kinds of Ownership Securities or shares Equity Shares: Equity shares are known as Ordinary Shares .

such shares must be offered to holders of existing equity shares in proportion. 1956 provides that Whenever a public limited company proposes to increase its subscribed capital by the Allotment of further shares. belongs to Equity shareholders. Each equity share carries one vote and a shareholder has votes equal to the number of equity share held by him. 4 Right to control or Voting Rights: Equity shareholders are the real owners of the company.They have voting rights in the meeting of the company and have a control over the working of the company. 5 Pre-emptive Right: To safeguard the interest of equity shareholders & enable them Maintain their proportional ownership.In the event of liquidation of a company.3 Claim on Assets: Equity shareholders have a residual claim on ownership of company’s Assets. thereafter. Shares so offered to existing shareholders are called Right Shares and their Prior right to such is known as pre-emptive right. The control in case of a company is rest with the Boards of Directors who are Elected by equity shareholders. Section 81 of the Companies Act. Directors are appointed by majority votes. . the assets are utilized first to meet the Claims of creditors & preference shareholders but everything left. .

Disadvantages of Equity Shares: 1 If only equity share are issued. equity shareholders are the real gainers by way of increased dividend. the company cannot take the advantage of trading on equity. he cannot be liable further for any losses of the company even at the time of liquidation. 4 Investors who desire to invest in safe securities with a fixed income have no attraction for such shares. 3 It is a permanent source of capital and the company has not to repay it except Under liquidation. Advantages of Equity Shares: 1 Equity shares do not create any obligation to pay a fixed rate of dividend.If a shareholder has Already fully paid the share price. there is a danger of over capitalisation. Their liability is limited to the value of share they have purchased.6 Limited liability: Although equity shareholders are the real owners of the company. . 5 In case of profits. 2 As equity capital cannot be redeemed. 4 Equity shareholders are the real owners of the company who have the voting rights. 2 Equity shares can be issued without creating any charge over the assets of the Company. 3 During Prosperous periods higher dividends have to be paid leading to increase in the value of shares in the market and speculation.

Cumulative preference shares are paid dividend for all the previous years in which Dividend could not be declared. so they have no say in the management of the company. A fixed rate Of dividend is paid on preference share capital. The second preference for these shares is the repayment of capital at the time of liquidation of a company. 3 Redeemable Preference Shares: Normally. the dividend is first paid on preference share capital. 2 Non. these shares have certain preferences as Compared to other types of shares.The company has a right to return redeemable preference share capital after a certain period. preference share capital is returned in full.Preferences shareholder do not have voting rights.Neither the company can return the share capital nor the shareholders can demand its repayment. These shares are given two preferences. . Whenever there are divisible profits. the capital is paid only at the time of Liquidation.Cumulative Preference Shares: The holders of these shares have no claim for the arrears of dividend. Types of Preference Shares: 1 Cumulative Preference Shares: These shares have a right to claim dividend for those years also for which there are no profits.Preference Shares: As the name suggests. After paying outside creditors. There is a preference for payment of dividend. Whenever the company has distributable profits.

6 7 8 Non-participating Preference Shares Convertible Preference Shares Non-Convertible Preference Shares Features of Preference Shares: 1 Maturity: Generally . preference shares resemble equity shares in respect of maturity. the dividend is first Paid on preference share capital.4 Irredeemable Preference shares: Those shares cannot be redeemed unless the company is liquidated. Preference shareholders have prior claim on income(dividend) over equity Shareholders. These are irredeemable and the company is not required to repay the amount during its lifetime. . 2 Claims on Income: A fixed rate of dividend is payable on preference shares.Whenever the company has distributable profits. 5 Participating Preference shares: The holders of these shares participate in the Surplus profits of the company. It is only at the time of liquidation that a company has to repay the preference shareholder after meeting the claim of creditor but before paying Back the equity shareholders except in case of redeemable preference shares.

(ii) preference dividend is payable only out of distributable profits & (iii) it is not deductible as an expense While determinig tax liability of the company.(ii) it entitles to a right to its holder prior to equity Shareholders and (iii) it does not provide a right to vote. .The interest on debentures is a charge on the profit and loss account of the company. Their claim is superior to those of equity Shareholder. As it includes some features of equity and other of debt financing. so they do not have any say in the management or control of the company.But they do not have any right in the surplus assets of the company. which is usually secured by a fixed or floating charge on the company’s property or undertaking and which acknowledges a loan to the company. A fixed rate of interest is paid on debentures. Hybrid Form of Security: Preference share capital represents a hybrid form of security. it has certain characteristics of debt financing such as(i) it carrries a fixed rate of dividend like interest.Claims on Assets: Preference shares have a preference in the repayment of capital at the time of liquidation of a company.” A debentureholder is a creditor of the company. At the same time .It resembles equity in the sense that (i) payment of dividend is not obligatory. Creditorship Securities: Debentures or Bonds: “ A debenture is a document under the company’s seal which provides for the payment of a principle sum & interest thereon at regular intervals. Control: Preference shareholders do not have any voting rights.

They have to be paid first before making any payment to the preference or equity shareholders in the event of liquidation of the Company. The default in payment of interest may cause winding up of company because the debentureholders may take recourse to law for the same.a company may issue irredeemable bonds or Debentures which have no maturity date. However.Features of Debentures or Bond: 1 Maturity: Although debentures provide long-term funds to a company. if any. debentureholders have priorty of claim on assets of the company.Unlike shares.Generally. 3 Claims on Assets: Even in respect of claim on assets. However. 2 Claim on Income: A fixed rate of interest is payable on debentures. it is under an obligation to pay Interest to its debentureholders. they mature after a specific period. they have a claim for the principal amount & interest due only and do not have any share in the surplus assets of the company. Even if a company makes no earnings or incurs loss. the debentures are to be repaid at a definite time as as stipulated in the issue. a company has a legal obligation to pay the interest on due dates irrespective of its earnings. . The company must pay back the principal amount on these Debentures on the given date otherwise the debentureholders may force winding up of the company as creditors.

debentureholders are creditors of the company and not its owners. they do not have any control over the management of the company. But. Since. the call feature provides advantages to the company at the expense of its debentureholders. II Internal Financing: Retained Earnings or Ploughing Back of Profits: The Ploughing Back of Profits is a techique of financial management under which all profits is retained or re-invested in the company. 5 Call feature: Issue of debentures sometimes provide a call feature which entitles the company to redeem its debentures at a certain price before the maturity date. .This process of retaining profits year after year & their utilisation in the business is also known as plouging back of profits. Such a phenomenon is also known As “ Self-Financing”or “Internal financing “.They do not have any voting rights to elect the directors of the company.4 Control : Since. they may take control over the company. the call price is usually more than the issue price. at the time of liquidation Of the company they have prior claim over shareholders & if remain unpaid.

As present day commerce is built upon credit. 2 Instalment Credit: This is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in instalments Over a pre-determined period of time.Generally. .The credit-worthiness of a firm and the confidence of its suppliers are the Main basis of securing trade credit. Short –term loans and Credits: 1 Trade Credit: Trade credit refers to the credit extended by the suppliers of goods in the normal course of business.It is mostly granted on an open account basis Whereby supplier sends goods to the buyer for the payment to be received in future As per terms of the sale invoice. the trade credit arrangement of a firm with its suppliers is an important source of short-term Finance.It may also take the form of bills payable whereby The buyer signs a bill of exchange payable on a specified future date.III Loan Financing: The third important mode of finance is raising of both (i)short-term loans and credits & (ii) term loans including medium & short-term loans. interest is charged on the unpaid price or it may be adjusted in the price.

These simply represent a liability that a firm has to Pay for the services already received by it. collection of accounts receivables . provision of finance and rendering of advisory services to their clients. Factors render services varying from bill discounting facilities offered by commercial banks to a total take over of administration of credit sales including maintenance of sales ledger. Accured Expenses or Accurals: Accured expenses are the expenses which have been incured But not yet due and hence not yet paid also. a firm gets immediate Payment for sales made on credit. fortnightly or weekly basis for the services already rendered by employees. specially the firms manufacturing industrial products prefer to take advance from their customers. Factoring or Accounts Receivable Credit: Another method of raising short-term finance is Through account receivable credit offered by commercial banks and factors.Factoring is becoming Popular all over the world on account of various services offered by the institutions engaged in it.Customer Advances: Some business houses get advances from their customers & agents against orders & this source is a short-term source of finance for them . It is a cheap source of finance and in order to minimise their investment in working capital. Thus . A commercial bank may provide finance by discounting the bills or invoices of its customers. interest and taxes. The most important items of accurals are wages And salaries. The longer the payment-period. Wages and salaries are usually paid on monthly.some firms Having long production cycle. . credit control and protection from bad debts . A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales. The greater is the amount liability towards employess or the funds provided by them.

Only a Company which is listed on the stock exchange. 25 crores can issue Commercial paper not exceeding 30 per cent of its working capital limit. firms having great demand for its products and services and those having good reputation in the market can demand deferred incomes. Like taxes. all the accured expenses can be used as a source of finance. Deferred Incomes: Deferred incomes are incomes received in advance before supp-lying goods or services in future. The Reserve Bank of India has laid down a number of conditions of determine eligibility of a company for the issue of commercial paper. accured interest and taxes also constitute a short-term source of finance. But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise Short-term funds.In the same manner. However. the Reserve Bank of India introduced Commercial paper in the Indian money market. Taxes are paid after collection and in the intervening period serve as a good source of finance. interest is also paid periodically while the funds are Used continuously by a firm. Commercial Paper: Commercial paper represents unsecured promisory notes issued by firms to raise short-term funds. These funds increase the liquidity of a firm and Constitute an important source of short-term finance. Thus. Even income-tax is paid periodically much after the profits have been earned. . has a net worth of atleast Rs. 10 Crores and maximum permissible bank finance of Rs. In India.

But . term loans exceeding one year are Also provided by banks. insurance companies Unit trusts and firms to invest surplus funds for a short-period. . A loan may be repayable in lump sum or instalments. mostly ranges from 91 to 180 days. a specified amount is sanctioned by the bank to the Customer.now-a-days . The borrower is required to pay interest on the entire amount of loan From the date of the sanction. Commercial paper is usually bought by investors including banks. The entire loan amount is paid to the borrower either in cash or by credit To his account. In case of a loan . The term loans may be either medium-term or long-term loans. Commercial paper is a Cheaper source of raising short-term finance as compared to the bank credit . Commercial banks generally provide short-term loans upto one year for meeting working capital requirements.The maturity period of commercial paper. the interest is calculated at quarterly rests and where repayments are stipulated in Instalments. Bank Loans: When a bank makes an advance in lump-sum against some security it is called a loan. in India . Disadvantage of commercial paper is that is cannot be redeemed before the maturity Date even if the issuing firm has surplus funds to pay back. the interest is calculated at quarterly rests on the reduced balances.

In the recent years many companies have accepted deposits from the public by offering higher rates of interest as compared to banks and post offices To meet their requirements of funds. The Public sector( Govt. companies ) have also started accepting public depoists. less liquid and without any tax advantage. there has been a tremendous growth both in the amount Of public deposits as well as in the number of companies accepting such deposits. .Public Deposits: Acceptance of fixed deposits from the public by all type of manufacturing & non-bank financial companies in the private sector has been a unique feature of Indian financial system. more risky.The importance of such deposits in financing of Indian Industries was recognized as early as in 1931 by the Indian Central banking Enquiry Committee. Inspite of the fact that public deposits are unsecured.